ch10-bai-tap-chuong-10

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Ch10 - bài tập chương 10 Corporate Finance (Trường Đại học FPT) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Ch10 - bài tập chương 10 Corporate Finance (Trường Đại học FPT) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by Hà Lê (easylife155@gmail.com) lOMoARcPSD|10797600

CHAPTER 10 The Fundamentals of Capital Budgeting Before You Go On Questions and Answers Section 10.1 1. Why are capital investments considered the most important decisions made by a firm’s management? Capital investments are the most important decisions made by a firm’s management, because they usually involve large cash outflows and once made are not easily reversed. These are usually long-term projects that will define the firm’s line of business and significantly contribute to the total revenue figure for years to come. 2. What are the differences between capital projects that are independent, mutually exclusive, and contingent? A project is independent if the decision to accept or reject it does not affect the decision to accept or reject another project. On the other hand, projects are mutually exclusive if the acceptance of one implies rejection of the other. Contingent projects are those in which the acceptance of one project is dependent on another project. Section 10.2 1. What is the NPV of a project? NPV is simply the difference between the present value of a project’s expected future cash flows and its cost. It is the recommended technique used to value capital investments, as it takes into account both the timing of the cash flows and their risk. Downloaded by Hà Lê (easylife155@gmail.com) lOMoARcPSD|10797600

2. If a firm accepts a project with a $10,000 NPV, what is the effect on the value of the firm? If a firm accepts a project with a $10,000 NPV, it will increase its value by $10,000. 3. What are the five steps used in NPV analysis? The five-step process used in the NPV analysis can be listed as follows: (1) Determine the cost of the project. (2) Estimate the project’s future cash flows over its expected life. (3) Determine the riskiness of a project and the appropriate cost of capital. (4) Compute the project’s NPV. (5) Make a decision. Section 10.3 1. What is the payback period? The payback period is defined as the number of years it takes to recover the project’s initial investment. All other things being equal, the project with the shortest payback period is usually the optimal investment. 2. Why does the payback period provide a measure of a project’s liquidity risk? The payback period determines how quickly you recover your investment in a project. Thus, it serves as a good measure of the project’s liquidity. 3. What are the main shortcomings of the payback method? The payback method does not account for time value of money, nor does it distinguish between high- and low-risk projects. In addition, there is no rationale behind choosing the cutoff criteria. For all these reasons, the payback method is not the ideal capital decision rule. Downloaded by Hà Lê (easylife155@gmail.com) lOMoARcPSD|10797600

Section 10.4 1. What are the major shortcomings of using the ARR method as a capital budgeting method? The biggest shortcoming of using ARR as a capital budgeting tool is that it uses historical, or book value data rather than cash flows and thus disregards the time value of money principle. In addition, as in the payback method, it fails to establish a rationale behind picking the appropriate hurdle rate. Section 10.5 1. What is the IRR method? The IRR, or the internal rate of return, is the discount rate that makes the net present value of the project’s future cash flows zero. The IRR determines whether the project’s return rate is higher or lower than the required rate of return, which is the firm’s cost of capital. As a rule, a project should be accepted if the IRR exceeds the firm’s cost of capital; otherwise the project should be rejected. 2. In capital budgeting, what is a conventional cash flow pattern? A conventional project cash flow in capital budgeting is one in which an initial cash outflow is followed by one or more future cash inflows. 3. Why should the NPV method be the primary decision tool used in making capital investment decisions? Given all the different methods to evaluate capital investment decisions, the NPV method is the preferred valuation tool as it accounts for both time value of money and the project’s risk. Furthermore, NPV is not sensitive to nonconventional projects, and therefore it is superior to the IRR technique and it gives a measure of the value increase/decrease to the firm by undertaking the project. Downloaded by Hà Lê (easylife155@gmail.com) lOMoARcPSD|10797600

Section 10.6 1. What changes have taken place in the capital budgeting techniques used by U.S. companies? Over the years, there has been a shift from using payback and ARR as the primary capital budgeting tools to using NPV and IRR instead. Managers today understand the importance of the time value of money and discounting and thus regard ARR as an inaccurate and obsolete decision tool. Self-Study Problems 10.1 Premium Manufacturing Company is evaluating two forklift systems to use in its plant that produces the towers for a windmill power farm. The costs and the cash flows from these systems are shown below. If the company uses a 12 percent discount rate for all projects, determine which forklift system should be purchased using the net present value (NPV) approach. Year 0 Year 1 Year 2 Year 3 Otis Forklifts − $3,123,450 $979,225 $1,358,886 $2,111,497 Craigmore Forklifts − $4,137,410 $875,236 $1,765,225 $2,865,110 Solution: NPV for Otis Forklifts: NPV for Craigmore Forklifts: Premium should purchase the Otis forklift since it has a larger NPV. Downloaded by Hà Lê (easylife155@gmail.com) lOMoARcPSD|10797600

10.2 Rutledge, Inc., has invested $100,000 in a project that will produce cash flows of $45,000, $37,500, and $42,950 over the next three years. Find the payback period for the project. Solution: Payback period for Rutledge project: Year CF Cumulative Cash Flow 0 (100,000) (100,000) 1 45,000 (55,000) 2 37,500 (17,500) 3 42,950 25,450 Remaining cost to recover Payback period = Years before cost recovery + Cash flow during the year $17,500 = 2 $42,950 per year 2.41 years   PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year) = 2 + ($17,500 / $42,950) = 2.41 years 10.3 Perryman Crafts Corp. is evaluating two independent capital projects that together will cost the company $250,000. The two projects will provide the following cash flows: Year Project A Project B 1 $80,750 $32,450 2 $93,450 $76,125 3 $40,325 $153,250 4 $145,655 $96,110 Downloaded by Hà Lê (easylife155@gmail.com) lOMoARcPSD|10797600

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